§ Do firms Prefer Debt?
§ The market value of equity has risen over time
§ The average debt-to-equity ratio tends to fall in bull markets,
and reverse in bear markets
§ Leverage ratios vary greatly by industry
§ Many firms retain large cash balances, reducing effective
leverage
§ Limits to the Tax Benefit of Debt
§ In the first place, a firm receives a tax benefit only if it is
paying taxes in the first place (taxable earnings)
§ Think about a firm with EBIT of $1000 and tax rate of 35%
§ With no leverage, the firm pays $350 in taxes
§ With high leverage and interest payment of $1000, the firm
pays no taxes
§ With excess leverage, there is no increase in tax savings
§ Limits to the Tax Benefit of Debt
§ There is no tax benefit from incurring interest higher than
EBIT
§ Limits to the Tax Benefit of Debt
§ The optimal level of leverage from a tax saving perspective is
the level such that interest equals EBIT
§ Of course, it is difficult to predict future EBIT precisely
§ Because there are disadvantages to excess debt (interest is
taxed more heavily than equity at investor level), this
uncertainty over EBIT will reduce the optimal level of interest
payment
§ The Low Leverage Puzzle
§ Firms tend to be under-leveraged than our analysis up to this
point
§ Key cost of debt missing from our analysis – increasing the
level of debt increases the probability of bankruptcy
§ If bankruptcy is costly , these costs might offset the tax
benefits of debt financing
§ Interest Tax Shield = Corporate Tax Rate x Interest
Payments
§ MM Proposition I with taxes:
The total value of the levered firm exceeds the value of the
firm
without leverage due to the PV of the tax savings from
debt:
V
L
= V
U
+ PV(Interest Tax Shield)
§
§
Chapter 16
Corporate Finance: The Core (4
th
Edition)
Berk/DeMarzo
